iHeart: The Alchemy of Transfers to Unrestricted Subsidiaries

Earlier this month, counsel for certain holders of iHeart’s Priority Guarantee Notes (PGNs) filed a motion seeking a 60-day extension, to January 17, 2017, of the deadline for filing their opening brief in their appeal of Judge Cathleen Stryker’s order in the captioned caseiHeartCommunications, Inc. f/k/a Clear Channel Communications, Inc. v. Benefit Street Partners LLC, et al (District Court Baxter County, TX). On May 24, 2016, the court granted iHeart’s petition for declaratory judgment and a permanent injunction in the dispute over whether the company’s capital contribution to its unrestricted subsidiary Broader Media, LLC constituted a “Permitted Investment” under the PGN indentures. The recent appellate activity provides a convenient opportunity to consider the court’s order, which has important implications for covenant compliance through transfers to unrestricted subsidiaries.

The Proceedings 

On December 3, 2015, Clear Channel Holdings, Inc., a wholly-owned restricted subsidiary of iHeart, contributed 100 million Class B shares of Clear Channel Outdoor Holdings Inc. (CCOH) to Broader Media, a newly formed wholly-owned subsidiary of iHeart.¹ Unlike Clear Channel Holdings, Broader Media was an unrestricted subsidiary of iHeart, and thus generally not bound by the restrictive covenants in the PGN indentures.

iHeart disclosed the capital contribution in an SEC filing on December 10, 2015. In the filing, it reported that the purpose of the transaction was “to provide greater flexibility in support of future financing transactions, share dispositions and other similar transactions.”

A group of PGN noteholders organized and sent a letter to iHeart asserting that the capital contribution breached certain covenants in the indentures, because it was not a Permitted Investment, and sent a notice of default on account of such breach. In anticipation of the possibility of the default notice, iHeart filed a complaint earlier that same day, seeking a temporary restraining order preventing the noteholder defendants from issuing false notices of default, and a declaratory judgment that the company was not in default by reason of the capital contribution.

Judge Stryker presided over a three-day preliminary injunction hearing in early April 2016 and a one-week trial on the merits in May. After considering the evidence and arguments, she entered judgment, granting iHeart’s request for declaratory relief that the capital contribution complied with the indentures. She also granted iHeart’s request for a permanent injunction rescinding the notices of default and permanently enjoining the defendant noteholders, and all persons acting on their behalf or in active concert or participation with them, from issuing new notices of default based on the capital contribution. Judge Stryker subsequently issued Findings of Fact and Conclusions of Law on July 5, 2016.

In her opinion, Judge Stryker held that the capital contribution constituted an “Investment” under the indentures because it was both a “capital contribution” and also “property transferred to ... an Unrestricted Subsidiary,” in compliance with the definition of “Investment” in the indentures. One of the PGN noteholders’ central arguments was that the stock contribution to an Unrestricted Subsidiary did not constitute a lower-case investment (under the definition of “Investment”) unless iHeart had a profit motive in undertaking the contribution. While Judge Stryker rejected this argument, she also found that iHeart did have a profit motive when it directed Clear Channel Holdings to make the capital contribution. The purpose of the capital contribution, she found, was to facilitate Broader Media’s purchase of iHeart debt at a discount, which would benefit iHeart financially.

The court then held that the capital contribution was a Permitted Investment under the indentures. iHeart had determined, in good faith and in accordance with the discretion that it was permitted to exercise under the indentures, that the fair market value of the capital contribution was $516 million, well within the available $600 million in the general investment basket.² The noteholders were left with nothing about which to complain, and the notice of default was therefore improper.³ The PGN noteholders filed their notice of appeal on August 22, 2016.

The Significance of the Ruling 

The iHeart maneuver involved the transfer of CCOH equity to a newly created unrestricted subsidiary. When CCOH subsequently declared a dividend, the unrestricted subsidiary used the proceeds of its share of the dividend to repurchase iHeart debt at a discount, something which the restricted payment covenant in the PGN indentures prohibited iHeart and its restricted subsidiaries from doing directly. But such a maneuver need not end there. Depending on the terms of its indenture, dividending up acquired debt back to the issuer or its restricted subsidiaries may enable an issuer to replenish the permitted investment basket, and the process may be repeated anew.

While iHeart utilized the alchemy of unrestricted subsidiaries to finance open-market purchases of debt, other uses can be envisioned. For example, an issuer could use the portal of an unrestricted subsidiary to facilitate a debt-for-debt exchange offer. The new debt, secured by the assets contributed to the unrestricted subsidiary, may be structurally senior to the old debt, particularly if the old debt is unsecured, creating a powerful incentive to participate in the exchange when the issuer is distressed, even at a substantial discount. Alternatively, assets contributed to an unrestricted subsidiary could be sold free of the constraints of the asset sale covenant, or be exchanged in an affiliate transaction without the need to comply with the strictures of the affiliate transactions covenant. And once again, depending on the formulation of the permitted investment covenant, these maneuvers could be repeated with judicious dividends that replenished the permitted investment basket.

The reasoning of the iHeart court appears sound under indentures as commonly drafted, and the likelihood that the decision will be overturned on appeal seems low. The basic canon of indenture interpretation is that parties will be held to the plain meaning of their documents, and absent ambiguity, courts will not rewrite the parties’ bargain on perceived equitable grounds.⁴ After iHeart, issuers will likely be looking to avail themselves of similar opportunities. Holders of indenture debt that play the chess game of analyzing their issuers’ moves will need to take the possibility of contributions to unrestricted subsidiaries into account. iHeart’s procedural moves – seeking a preemptive injunction against a default notice – might also be emulated. So, while emanating from a Texas state court not typically considered a trendsetter in the interpretation of indentures, the iHeart case, and the potential for surprises on appeal, remains worth watching.

¹ CCOH is an indirect subsidiary of iHeart. Approximately 90% of the outstanding shares of CCOH are owned by iHeart affiliates. CCOH has two classes of stock: Class A shares, which are publicly traded on the New York Stock Exchange and are entitled to one vote per share, and Class B shares, which are held by iHeart and its affiliates and are entitled to 20 votes per share. Under the CCOH Articles of Incorporation, when a Class B share is transferred to any entity that is not an iHeart affiliate, it automatically converts into a Class A share.

² The court noted that iHeart had properly relied on the publicly traded price of CCOH Class A shares on the New York Stock Exchange of $5.16 per share on the day it made the capital contribution.

³ Subsequent to the decision, on July 29, iHeart commenced litigation against the defendant noteholders and others in Texas state court seeking to recover damages caused by the noteholders’ “misconduct,” including their allegations that the company had breached the indentures.

⁴ The iHeart court found that the offering circulars for each of the PGNs disclosed to prospective purchasers that, in the past, iHeart’s unrestricted subsidiaries had repurchased iHeart debt at a discount. While tilting the equities away from the noteholders somewhat, this observation does not appear critical to the holding of the case.